Time for the Fed to Step Up, What the Election Won’t Affect, and More Takes From the Top Moody’s Economist

Wild Wall Street volatility. An election between candidates with dramatically different visions for the U.S. Rocky real estate markets and rising consumer debt. In the waning days of summer 2024, uncertainty reigns. 

As we hurtle toward a momentous fall, The RMA Journal reached out to Moody’s Analytics Chief Economist Mark Zandi for his perspectives on where the economy stands today and where we might be headed. In our interview, Zandi provided a pre-election economic update touching on the stakes of the election for banks, the path of inflation and interest rates, when the housing market might finally come to life, and the obscure but consequential owner’s equivalent rent metric. (Zandi will provide a post-election economic analysis at RMA’s Annual Risk Management Virtual Conference in December.) 

On the Path of the Economy 

RMA JOURNAL: Since the last time we interviewed you, and you predicted a soft landing, it seems like you have been joined by more economists who feel that way. Is that still what you see? 

ZANDI: Yes, the economy is coming in for a soft landing. Key to this optimism is that inflation continues to moderate and is closing in on the Federal Reserve’s inflation target, which will allow the Fed to soon begin cutting interest rates. The previously painfully high inflation was mostly due to the impact of the pandemic on supply chains and the labor market, and the Russian war in Ukraine and its impact on oil, natural gas, and agricultural prices. As the economic fallout from these shocks have faded to the background, inflation has come down, allowing the Fed to avoid the rate hikes that would result in recession. 

How might the economic path and the picture for the banking industry differ depending on who wins the presidential election?  

Much depends on the makeup of Congress, as this will determine how much of the next president’s agenda will be implemented. If it is a Republican sweep, more of former President Trump’s proposed economic policies, including much higher tariffs, deportations of unauthorized immigrants living in the U.S., and deficit-financed tax cuts, will be implemented. This will result in higher inflation and interest rates and a diminished economy, compared to the current policy status quo. The policy status quo is likely if Vice President Harris wins the Presidency. Former President Trump and VP Harris will also meaningfully differ on regulation of the banking system, with Harris pursuing stiffer regulations than the former president. 

Will there be ways the economy will be the same next year no matter who wins? 

Regardless of the makeup of government on the other side of the election, the economy should continue to perform reasonably well through this time next year. Inflation should fully return to the Federal Reserve’s target and the Fed will be quickly normalizing rates. The Treasury yield curve will become positively sloped again by next fall. There are plenty of threats to this optimism, but the most likely scenario is for the economy to soft land and the economic expansion will continue on. 

Could the presidential campaign itself over the next three months create events that lead to economic hiccups? 

The election is likely to be historically close and thus contentious, and odds are uncomfortably high it ends up being decided by the courts. However, unlike in the Bush vs. Gore election, in which Gore gracefully relented, that is much less likely to happen this go around. If so, this could result in political and social unrest, which would be a heavy weight on investor, business and consumer sentiment. There is no upside to the economy if this is how things play out, only downside. 

On Insurance Prices 

How are rising insurance prices affecting consumers, their ability to pay bills, and their appetite for spending? 

Quickly rising vehicle and homeowners’ insurance premiums are meaningfully adding to inflation and biting into consumers’ purchasing power. The higher vehicle insurance premiums largely reflect the impact of the pandemic, which shut down global vehicle production, causing vehicle prices and thus repair and maintenance costs to jump. However, premiums have now largely caught up, and should increase at a more typical pace going forward. Homeowners’ insurance will continue to rise quickly reflecting the mounting costs associated with climate change and higher tort costs. This will impact real estate markets, as it weighs on demand and thus house and commercial real estate prices, particularly in states such as Florida, Texas, and California. 

On Geopolitical Risk 

How could geopolitical risks manifest in ways that harm economies in the next several months? 

The most immediate geopolitical threat is the mounting conflict in the Middle East, which could impact oil production in the region, causing prices to jump. Nothing does more damage more quickly to the U.S. and global economies than a significant increase in fossil fuel prices. Heightened tensions between the U.S. and China could also boil over, severely impacting global trade and production. Other geopolitical threats that could destabilize financial markets and the economy under certain scenarios include the Russian war in Ukraine and North Korea. 

Speaking of oil prices, American University history professor Allan Lichtman’s claim to fame is his system that predicts presidential election winners. You recently wrote an article saying it might be enough to simply look at the price of gas. Is that because people are always taking note of gas prices as they drive around and fill up? 

Historically, consumer sentiment is closely tied to the price of a gallon of regular unleaded gasoline. Most of us purchase gas once a week, and we see its price daily. Gas is something we can’t do without, and for lower-income households, if gas prices go up they quickly have to make tough choices about what not to purchase. Gas prices also have an outsized impact on investors’ and consumers’ inflation expectations, and thus potentially monetary policy and interest rates. A national average of $3.50 for a gallon of regular unleaded appears to be a significant threshold. [As of August 11 the national average was $3.45, according to the AAA auto club.] If prices are lower, consumers feel good and inflation expectations are tame. But if prices rise much above this threshold, consumers quickly turn dark and inflation expectations rise. 

On Fed Action 

Even before the recent stock market volatility fanned recession fears, you were saying the Fed had already waited too long to cut the fed funds rate. Can you explain why you feel that way? 

The Fed has achieved its dual mandate of full employment and low and stable inflation. Indeed, the unemployment rate is 4.3% and on the rise, and inflation as measured by the consumer expenditure deflator is 2.5% and steadily trending lower. Moreover, excluding the implicit cost of homeownership or owners’ equivalent rent, inflation is firmly at 1.5%. Given how difficult it is to measure OER and how lagged it is by construction, I would not include it when judging whether inflation is low and stable. If the Fed has achieved its goals, then why is it holding to a near 5.5% funds rate target? This is well above any estimate of the equilibrium rate— the rate which is neither restraining or supporting growth. And as long as the Fed keeps rates so high, the greater the risk that something in the job market or financial system breaks. And if it does, it will be too late for the Fed to fix things. 

Why might higher for longer interest rates be a strain on not only customers and banks, but the financial system itself?  

The higher for longer rate strategy ensures that the yield curve remains inverted, which puts significant financial pressure on banks and nonbanks. It also puts pressure on lower-income households and small businesses who are paying the higher rates on credit cards, consumer finance loans and small business loans. Of course, higher rates also put downward pressure on commercial real estate prices, raising the risks of default. 

On the CRE Market 

We continue to see conflicting headlines about CRE in general and office space in particular. The Wall Street Journal just ran a piece saying that a surge in commercial property foreclosures suggests we may be nearing the bottom in the sector. But plenty of other articles say there is more pain to come. What do you see on the horizon? 

Most of the adjustment in CRE prices is over, save perhaps Class B and C office properties in big urban centers. This, combined with lower rates, if the Fed does ease policy as soon as anticipated, should limit future CRE defaults. Forbearance by lenders and regulators has attenuated the adjustment process in the CRE market, but it has also forestalled more serious credit problems. 

On the Housing Market 

How sensitive are housing market dynamics to drops in the mortgage rate? And what role does the fact that so many potential sellers are on the sidelines with their 3% mortgages play? 

I expect 30-year fixed mortgage rates to settle in between 5.5-6% as the Fed eases and the yield curve normalizes. Homeowners are beginning to realize rates aren’t going back to 3%, unless the economy is in recession. As homeowners’ rate expectations shift higher and demographic changes pressure households to move, the single-family housing market will come back to life. However, this will take time, and home sales and mortgage originations are unlikely to normalize for two to three years. 

What might the overall effect on housing prices be if mortgage rates do drop a couple percentage points? 

The push and pull of lower mortgage rates on housing demand and supply is likely to be more –or less a draw. I expect national house prices to effectively go sideways over the next several years. When combined with lower mortgage rates and rising household incomes, housing affordability should slowly be restored. Of course, if national house prices are flat, that implies some modest price declines in parts of the country, probably in the South and West given how high they rose during the pandemic, more construction, and higher homeowners’ insurance rates. 

On Generative AI 

With all the investment in generative AI the past two years, do you expect these projects to contribute positively to economic growth and/or corporate profitability in 2025? 

AI should support productivity growth in coming years, although I think it prudent to assume it will add to business-as-usual productivity gains economy-wide, and not extraordinary productivity growth. There is too much uncertainty regarding how big the AI productivity gains will be and when they will occur to bank on them. Historically, new technologies have only had big impacts on productivity after new businesses form that optimize around the new technology. AI may be different, but I wouldn’t plan on it. 

On Consumer Credit Quality 

Consumers have spent their pandemic savings, and personal credit metrics (credit card delinquencies, amount outstanding, etc.) are showing signs of stress. Yet we still saw surprising positive GDP growth in July. Is the consumer now deficit-spending the economy to growth, and are we heading for trouble? 

No, middle and higher-income households have little debt, except for perhaps a mortgage with a low locked-in interest rate. High-income households, which do the bulk of the spending, also have plenty of excess savings and other assets. Lower-income households are under pressure, thus the high credit card delinquency rates, but even here, delinquencies are set to roll over given tighter underwriting since last year’s banking crisis, and the Fed easing that is set to occur. 

On the Aftermath of the Banking Crisis 

Final question—how would you characterize the way banks and the banking system have responded to the liquidity crunch and handful of regional bank failures last year? 

The operating environment for the banking system has been difficult, including the inverted yield curve, weaker credit quality, slow loan growth, and rising regulatory costs. Nonetheless, the banking system has managed through admirably well since last year’s bank failures, and operating conditions are set to improve. Much depends on the Fed lowering rates at their September meeting, which now appears likely given the recent volatility in financial markets and worries about the strength of the job market. The economy is set to soft land, just as long as the Fed follows through on rate cuts as are widely expected.